Classification of Expenses: Suggested Best Practices for Year-End
Rather than listing every expense on the income statement individually, similar payments are typically grouped together and labeled according to Generally Accepted Accounting Principles (GAAP) or industry conventions. For small businesses, classifying expenses into the proper category can be incorporated into routine processes, such as bill payment, but extensive classification can get more complicated. Here are four best practices to lessen the work of preparing financial statements or tax returns at year-end.
1. Know Your Industry's Standards
Each industry has slightly different conventions for classifying expenses. Manufacturing companies, for instance, may classify the expenses of cost of goods sold (COGS), such as freight, storage, and factory overhead that goes into producing their products. But expenses can differ from industry to industry. Tech companies will list research and development as expenses, while financial institutions will report on interest. As your small business gains momentum, you can ensure that your expenses are grouped properly by consulting a tax or accounting professional before setting up your in-house bookkeeping process. For more information, refer to the Small Business Administration.
2. Model Expense Line Items After Tax Returns
For ease of tax reporting, expenses can be classified to match year-end tax reporting requirements. Examine company tax returns from previous years to determine the required reporting format for expenses, and then group like expenses to match the proper IRS categories. If a home office or car is used for business purposes, file supporting documentation with your business expenses and categorize them appropriately. When combining business with personal travel, some of the expenses can be reported on your company financials and qualify for a tax deduction.
3. Understand Capitalization of Asset Purchases
According to GAAP, not all business expenses can be deducted in full as incurred. Items such as start-up costs or purchased assets (such as property and equipment) must be recorded on the company's balance sheet and expensed through the depreciation or amortization line item on an income statement. For proper classification of expenses, items purchased to fund a small business must be reviewed and properly categorized as an asset or an expense. For example, improvements to property are counted as an asset, not a repair expense. If you're unsure about the proper expense classification, consult an accounting or tax professional.
4. Use Accounting Programs to Properly Classify Expenses
Today's accounting programs are versatile enough to handle different industries' expense classifications. Many online accounting programs have pre-filled templates with expense line items such as office supplies, meals, entertainment, and advertising costs. These are the same classifications listed on IRS tax forms. Accounting programs with built-in expense categories make compiling financial statements easier. Reporting features also contain properly formatted financials that can be generated with a mouse click. If the standard reports do not meet a company's specific needs, data can be exported to a spreadsheet for further customization.
Proper classification of expenses is essential to producing professional-caliber financial statements. Your company is unique, and not every component will neatly fit into specific classifications. That is why knowing your specific industry's standards, looking to prior tax returns, classifying asset purchases, and using simplifying accounting programs may relieve stress for you and your business come year-end.